You may think I’m insane to promote an oil & gas company these days, what with oil prices teetering on the edge of a cliff and oil & gas equities looking very expensive. But there’s one that I think you should certainly keep your eye on. Advantage Energy Income Fund (TSE: AVN.UN) appears to be turning the corner from years of poor performance. First of all, AVN is primarily a natural gas producing trust, and I am much more bullish of natural gas than I am of crude oil. It has exposure to the right assets and appears to be overlooked by the market given how cheap the trust units appear.

If you believe high oil and gas prices are here to stay and that natural gas will play an increasingly important role in meeting the world’s future energy demands, then AVN is definitely an investment you should consider for the long term, but it could be in for a bumpy road in the near term.

Data as of July 8, 2008

About Advantage Energy Income Fund
Advantage is involved in the exploration for and production of oil and natural gas in Western Canada. Its properties are located in Alberta, Northeastern BC and Southeast Saskatchewan. Roughly 65% of their total production is natural gas, the other 35% being crude oil. It’s just another one of the many junior oil and gas trusts from Alberta.

Past Performance

Past weakness in the stock was mostly due to the trust struggling to maintain its high payout ratio. A number of distribution cuts occurred from 2005 to 2007, and the unit price suffered as a result. Today, the trust’s payout ratio is just 53%, and management has indicated that there it is highly unlikely they’ll need to cut again. Judging by the trust’s performance since the beginning of the year, it appears the market believes management has turned things around.

Oil and Gas Prices
Over the past month what can only be described as an anomaly has been unfolding within the oil & gas sector. Oil and gas prices have been steadily reaching new highs (well, until the last two days that is), however oil & gas equities, whose profits are derived from these commodity prices, have seen lackluster performance. Case-in-point, natural gas is up over 15% since the end of May yet AVN is down over 12% since then.

When valuing companies that produce oil and natural gas, you must make assumptions about the long term price for oil and gas in order to estimate the company’s revenues. Given how quickly oil and gas prices can move from one day to the next, you’re better off erring on the side of conservatism when making price assumptions. However, after the latest run in oil and gas prices most analysts’ assumptions are looking a little too conservative. As it seems, analysts across the street are valuing these companies using commodity price assumptions of $90 - $110 for crude oil and $8.00 - $10.00 for natural gas. If oil and gas prices stay at $130 - $140 and $12.00 - $13.00, respectively, then we should expect to see analysts’ price assumptions move significantly higher – which means much higher target prices. Even a 20% correction in current commodity prices would leave current assumptions more than safe.

Despite my recent articles about oil prices Oil Prices Gone Wild and HOD ETFs – A Bearish Indicator For Oil? I am a bullish on crude oil over the long term. I am still looking for a material correction in crude oil prices, but theoretically, any correction in crude oil shouldn’t affect too many oil & gas equities right now since a lot of them never really participated in the latest bull-run. Besides, as mentioned before, AVN is primarily a natural gas producing trust.

Q1 Results
AVN reported Q1 results in mid May, which were very good. Production for the first quarter was 33,133 BOE/d, an increase of 14.2% over last year’s first quarter and ahead of most expectations on the street. Also, revenues were up 20% year-over-year and cash flow was up 44% YOY. The trust sighted higher oil and gas prices as the major contributor to better revenues and cash flow - during the first quarter of the year, oil prices averaged around $100 per barrel, while natural gas prices averaged around $9.00.

Looking ahead to Q2 (and the rest of the year) expect revenues to be stronger given that oil prices are averaging roughly $125 and natural gas prices are averaging around $11.50 this quarter. AVN does hedge roughly 60% of its natural gas production and roughly 40% of its crude oil production, so commodity price increases won’t affect this portion of production, but the rest is sold at current market prices. Production numbers may be a bit weaker given that much of the oil and gas produced by AVN relies on third party pipelines for transportation and it sounds like there have been maintenance outages at various third party pipelines during the quarter. These outages should be widely expected, and I would expect that a production shortfall is now well priced into the units, but there is the chance the market will overreact to any shortfall in production (especially given how much of the float is owned by retail investors – discussed below). Overall, the quarter and the remainder of the year look generally good from a production/revenue perspective.

Montney Exposure
The Montney region in northern Alberta and BC is said to be potentially one of the largest economically viable resource plays in North America. This area has huge reserves of natural gas that until recently technology has not allowed producers to access. Larger companies like EnCana (TSE: ECA) and ARC Energy Trust (TSE: AET.UN) announced earlier this year that they would be increasing capital spending in the Montney region. The resource potential of this region is a no-brainer. The only issue is the state of the region’s current infrastructure (i.e., pipelines). Much more pipeline capacity is needed in order for these companies to really ramp-up production. Fortunate enough, capital spending on facilities and pipelines in this area has significantly increased recently.

AVN has a significant presence in the Montney lands, although management has been far more conservative than its competition when advertising this. In fact, AVN’s Montney lands reside right next to EnCana’s, who have seen extremely strong drill results. AVN recently announced they will increase their 2008 capital budget by $39 million to develop their Montney assets.

For nearly all companies who have exposure to this region (eg. EnCana, Duvernay Oil, Celtic Exploration, Galleon Energy, Crew Energy, West Energy, Trilogy Energy Trust, ARC Energy Trust, Storm Exploration, among others), the market has ascribed significant premium valuations. Given that AVN trades at a discount to its peers, it seems as though the market is overlooking its exposure. This is probably due to how thinly held AVN is among institutional investors (only 12% held institutionally), meaning less sophisticated retail investors own the majority of the public float.

Suffice it to say, this is an extremely sought after region, and any company who has exposure to this region has seen, and should continue to see, their share price perform very well.

Large Tax Pools
Canada’s new income trust tax reform. In 2011, income trusts will be taxable just like any other corporation. AVN, however, has roughly $1.7 billion in tax pools (one of the largest in this space) that it can use to offset corporate income taxes in the future, thus allowing it to remain not taxable well past 2011.

Prior to 2011 these tax pools allow the trust to maintain a low payout ratio (remember income trusts’ are required to maintain a high payout ratio in order to keep the tax exempt status) as they can offset any taxes payable with the tax pool funds. You may think AVN’s motivation to keep the payout ratio low is a bad thing, but keep in mind this is a growth story, so we’re looking for management to retain as much cash flow as possible for growing the business. Besides, at these prices the units are already yielding over 12%.

Finally, a large tax pool base also improves the trust’s attractiveness from an acquirer’s point of view. Any company on the acquisition warpath would certainly place a premium on a large tax pool base – the acquirer gets to use these tax pools in the same way the trust did.

Upcoming M&A Activity
It has been widely speculated that M&A activity in the Canadian oil & gas space should pick up in the near term, especially if the credit market begins improving. First of all, there is a lot of room for consolidation among Canadian oil & gas companies. The simple fact of the matter is that there are far too many companies operating in this space.

The second reason for an expected increase in M&A activity is India and China. Both countries have publicly stated they are interested in picking up Canadian oil & gas assets.

Advantage is relatively cheap compared to its peers and does have a favourable tax pool base. If and when the acquisition spree begins, expect AVN to be right in the thick of it.

Financials
I’m not going to go through all the financial statements for the AVN in this article (you can find them on the trust’s website) or perform an entire ratio analysis, but what I will say, is that the trust does carry quite a bit of debt on its balance sheet. At the end of the last quarter the trust had roughly $1 billion of debt. This compares to short term assets of just over $100 million. This may seem alarming at first, but this is a small, growing trust that has all of its cash flow tied up in capital expenditures and distribution payments to unit holders. The trust did generate nearly $25 million in cash flow before capital expenditures last quarter– so if the trust was really in a bind to pay back some debt, then halting capital expenditures a few quarters should be sufficient.

Reserves and Production (for anyone who cares)
The trust has grown primarily through acquisitions over the years. These acquisitions have allowed AVN to amass a strong portfolio of oil and gas reserves, which has in turn lead to increased oil and gas production over the years.

Reserves: It’s proved plus probable reserves (industry convention identifying oil and gas reserves that are likely to be recoverable) at the end of 2007 were 152,203 thousand barrels of oil equivalent (mBOE) [Note: BOE is a unit of energy based on the energy released by burning one barrel of crude oil. This unit is used so you can combine oil and gas reserves into a single measurement (for anyone that cares, 1BOE is roughly 6000 cubic feet of natural gas)]. 63% of this number consists of proven reserves, meaning they have a 90% certainty of being produced.

Production: The trust’s total natural gas production in 2007 was roughly 117 million cubic feet per day (MMcf/d). Crude oil and natural gas liquid production were 8,090 barrels per day (bbls/d) and 2,372 bbls/d, respectively. On a BOE basis, 2007 production came in at 29,962 BOE/d.

Ownership Disclosure: I currently own units of Advantage Energy Income Fund (TSE: AVN.UN).

Disclaimer: Any information contained in the above article represents my opinions only, and should not be construed as personalized investment advice. I cannot assess, verify or guarantee the suitability of any particular investment to any particular situation and the reader of the article bears complete responsibility for its own investment research and should seek the advice of a qualified investment professional that provides individualized advice prior to making any investment decisions. All opinions expressed and information and data provided therein are subject to change without notice.